What are the basic types of IRR stress tests?

(This post is part of a series which provides a basic overview and discussion of interest rate risk stress-testing.)

If you read the latest IRR Advisory or the previous FIL on IRR you might get the impression that there are a myriad of ways you can stress test IRR. And I guess technically you would be correct. Confused probably, but correct. They throw around so many “official” or “analytical” words that it’s hard to know what’s important and what’s not.

I’ll try to simplify things for you. There are two basic types of IRR stress-tests. That’s it, just two. Can you hear the data geeks and other analytical types screaming at me right now?

I would bet that depending on what expert you talk to they could list anywhere from five to twenty different types of IRR stress-tests.

Well from my perspective (a practical A/L modeler for Main Street community banks) there’s only two:

Earnings simulations

Equity Value simulations

That’s all that’s really practical for 99% of community banks. The term the OCC uses for it is “practicable” (OCC Bulletin 2000-16) These two types can be pulled straight out of the practical definition of IRR for banks:

The possibility that interest rates will change in the future and that such changes will cause economic losses that were unexpected. Losses will be reflected as losses of income or losses of (equity) value; or both.

We measure possible losses in income by running an earnings simulation.

We measure possible losses in value by running an equity value simulation.

Banks can certainly differ in the amount of IRR they have. Most of the time the differences are due to timing. Is the risk short-term or long-term? In other words - how will the bank’s risk manifest itself? Is it a relatively short-term exposure – meaning that changes in interest rates will begin to adversely impact the bank’s margin within one year? Or will it take some time for the impact to show-up in the bank’s income (i.e. longer-term risk)?

While most bank boards are likely to only be concerned about the impact on earnings (i.e. short-term risk) it is clear that the examiners want management and the board to focus on long-term risk as well:

So next time you start talking with your examiner, auditor, or analyst about IRR stress-tests, be sure you know what type of stress-test you’re talking about. Are you measuring short-term risk? Then you’re discussing an earnings simulation. Or are you measuring long-term risk? If so, then you’re discussing an equity value simulation.

As I continue this series you’ll see why it is necessary to make a distinction.